Helping clients invest tax-efficiently

No one ever said that choosing investments is a simple business. For any investor, several factors need to be considered, including age, investment objectives and one’s willingness and ability to tolerate risk. There’s also the impact of taxes on investment returns — the focus of this column.

Tax treatments can enhance or diminish returns from different types of investments. This is particularly true when investments are held in non-registered accounts and taxes must be paid as investment income is earned and gains are realized.

Everyone wants the best possible after-tax return, and it can be achieved by balancing not only an investment’s risk in relation to potential return but its risk in relation to after-tax return. The reasoning is simple: tax-efficient investing reduces or defers taxes, allowing investors to keep more of their money working for them.

Let’s evaluate the tax treatment for the three basic types of investment returns: interest, capital gains and dividends.

Interest is taxed as ordinary income in the year it is received (or earned), according to the recipient’s marginal rate of taxation. Depending on where you live in Canada, interest income will be taxed at a marginal rate as high as Quebec’s 48% or as low as Alberta’s 39%. Interest income is the least tax-efficient investment return.

Capital gains taxes are also calculated according to a person’s marginal tax rate, with the crucial difference that the investor is taxed on only 50% of the gain on an investment. The marginal tax rate for capital gains ranges from a high of 24% in Quebec to a low of 19.5% in Alberta. Capital gains are included in income only when they are realized, i.e., when an investment is sold.

Capital gains from mutual fund investments receive similar treatment. If a mutual fund realizes a capital gain, the holder receives a distribution, 50% of which is then included in taxable income.

Capital losses, not unusual these days, also have their uses. While they cannot be used to offset other types of income, they can offset capital gains in the same taxation year. Capital losses can also be carried back to offset gains in the previous three years or be carried forward indefinitely.

The taxation of dividends is a somewhat more complicated issue. Dividends, the distribution of a portion of a company’s earnings, fall into two classes: eligible and non-eligible. The former are generally those distributed by publicly traded Canadian companies, while the latter are generally paid by private corporations.

Eligible dividends are grossed up by 45% and non-eligible dividends by 25% to produce a taxable income total, which will then be taxed at the individual’s marginal rate. Once the basic tax is calculated, it is reduced by the federal dividend tax credit. This amounts to 19% of the grossed-up taxable income total in the case of eligible dividends and 13.3% of the total for non-eligible dividends. After the dividend tax credit is taken off, you are left with net federal tax payable. A similar tax credit exists in each of the provinces.

The taxation of dividends is complicated by the dividend gross-up and tax-credit mechanism. Dividend taxation is designed to reflect the fact that the corporation paying the dividend has already paid tax on its profits. At the end of the day, for eligible dividends, marginal rates currently range from a high of 29.7% in Quebec to a low of 14.56% in Alberta, while marginal rates for non-eligible dividends run from Quebec’s high of 36.35% to Alberta’s low of 27.73%.

Sadly, preferential tax treatment doesn’t extend to dividends from foreign companies. Dividends from abroad are taxed as ordinary income, just like interest.

Rating the returns

So, how do interest, capital gains and dividends stack up against each other? Suppose an individual realizes $10,000 on an investment and is in the top marginal tax bracket. Based on the current tax treatments outlined above, the following table summarizes what an individual would end up with, depending on the form of the investment gain:

	Alberta	Quebec
Eligible dividend	$8,544	$7,030
Capital gain	$8,050	$7,600
Non-eligible dividend	$7,227	$6,365
Interest	$6,100	$5,200

Clearly, an eligible dividend in Alberta, producing a net return of $8,544, is the best option given the province’s low tax rates. The other extreme is an interest-bearing investment taxed in Quebec. There, the investor would be left with little more than half of the initial return.

Remember, though, that tax treatment is only one factor in deciding the type of investment returns investors should seek. If they are young and won’t need income for many years, capital gains may be the best bet because of the ability to defer tax until the gain is realized and thus the potential for higher returns. Someone who’s older and requires a regular income stream, however, might want to opt for eligible dividends, even though they will be unable to defer receipt of the dividends or the resulting tax bill. And if an investor seeks stability, interest-bearing investments have appeal, despite the fact that they carry the highest tax rate.

Tax efficiency also depends on where investments are held. Generally, investors should hold their most tax-efficient investments in non-registered accounts. This would include stocks liable to generate the greatest capital gains over time as well as eligible dividend-paying stocks. Alternatively, the least tax-efficient investments — interest-bearing investments, foreign stock or non-eligible dividend-paying stock — should generally be domiciled in registered accounts in order to defer and potentially reduce the eventual tax bill.

Some product options

Tax efficiency is just one of the factors to consider in choosing investments. Advisors should stress the need to balance tax questions against other considerations, as well as pointing out that there are tax efficient products available. Some fund companies offer a capital structure mutual fund product that allows investors to switch and rebalance non-registered investments without immediate tax consequences. They also offer the prospect of tax deferral by reducing taxable distributions. Unlike typical mutual funds, however, all the classes of the capital structure fund are held within one corporation. This means that any capital gains that arise from switching can be deferred within the corporation. Investors in the fund enjoy tax-deferred compound growth, which eventually increases the potential value of the investment.

Some fund companies also offer tax-efficient systematic withdrawal services. These services are structured in such a way that monthly cash-flow distributions consist primarily of a return of capital, which isn’t subject to tax. With such plans, taxes are deferred until the investor depletes the initial investment or decides to sell.

A tax-efficient systematic withdrawal service has benefits beyond tax deferment. It capitalizes on tax-favoured dividends and capital gains and can even reduce clawbacks for government benefits like Old Age Security. Return of capital as a source of cash flow can help preserve and grow investments and, unlike most guaranteed investment certificates or annuities, give investors ready access to their money.

Tax-efficient investing has many layers. It clearly requires some thought on the part of investors, simply because it raises issues that must be seen in relation to other investment factors and objectives. In reconciling these factors, advisors have much to offer their clients, whether it’s information about the impact of taxation on different types of investment income or products that can help defer and reduce taxes while improving overall returns.